This article is a continuation of part 1, I posted a few weeks ago. Here, I’ll try to explain how did we went about coming up with valuation of our choice of startup – Ridevert. There are several key factors that VCs generally look at while valuing a startup. Some of the most prominent ones are:
- How experienced are the founders?
- How many users does company have or can potentially have?
- What is the industry growth potential?
- What are the chances company might get acquired in near future? (exit possibility)
- How much control they’re getting in the firm? (board seats)
- How risky is the deal? (includes factors such as options pool, liquidation preference, anti-dilution clause, et al.)
- How coachable management/founders of the firm are?
- What is VC’s circle of competence? (industry knowledge and ability to guide a young startup)
Now, some of these may seem pretty obvious, but in reality, they are that much more complicated to quantify. Most difficult part about valuing a startup is it’s a business with virtually no cash flows. A startup is like a black-box, where you can see the money going in, but you’re not sure how much will come out? When it will come out? and under what circumstances? Traditional means such as Discounted Cash Flow (DCF), Book Value, or Liquidation Value methods can’t be applied because there are no tangible assets, no numbers to put in spreadsheets and there is no direct way to determine weighted average cost of capital (WACC) for the business. Here’s how we valued Ridevert:
Step 1: Find a comparable transaction in the past
The approach we took is commonly known as Comparable Transactions Methods. Essentially, what this method entails is to find a comparable company or deals(transactions) in the past and appropriately discount the value of company at hand based on some of the factors mentioned above. Ridevert, as I described in part-1, is a bike advertisement company, which pays users to put ads on their bike based on number of miles they cover with a particular ad on their bike. Luckily, we found a similar company, Wrapify, which has very similar business model except for the fact it is an advertisement platform for car users instead of bike users.
Step 2: Discount the firm based on differences
On one hand, US has about 250M cars and about 100M people commute to work daily in their cars. On other hand, according to Statista, about 60M people owns a bike in the US. For sake of simplicity, we assumed 10% of total bike owners use it for daily commute (per business model of Ridevert, we presumed that only people, who use bikes on a regular basis are potential target customers, hence excluding people, who use bikes occasionally or solely for recreational purposes). Therefore, the potential market size for Ridevert is about 6M people. That makes Ridevert’s target market size about 6/100 = 6% of Wrapify’s market size.
Step 3: Calculate the right equity for right amount
Our team did a bit of digging to find how Wrapify funded itself in the past. We found that they raised $1M from nine different investors at pre-money valuation of $3.5M in series A funding back in 2015. This data made our job much easier than it would have been had we not found these statistics on crunchbase. Ridevert’s pre-money valuation at 6% of $3.5M comes out to be about $210K. Moreover, for $1M investment, investors got 1/(1+3.5) = 22.22% share in Wrapify. Following the same analogy, team decided to invest 60K in Ridevert to take a share of 22.22% (60/270) at a post-money valuation of $270K. Furthermore, for the benefits describe in part-1, akin to Wrapify investors, we also decided to opt for convertible bonds as opposed to direct equity in the firm.
Step 4: Growth Factor and Exit Strategy
Exit strategy is one of the most critical aspect of any venture capital/private equity deal. Since Ridevert has low fixed cost of operations, we assumed a modest growth factor of 3X in initial two year period and 2X in year-3 and year-4 respectively. These growth factors led us to a market value of $3.24M at the end of four years. For details, please refer the spreadsheet. A 22.22% share of that turns out to be $720K. Basically, we have converted $60K investment to $720K in a span of 4 years. That translates to a return on investment rate of whopping 1100%! The compounded annual growth rate (CAGR) on the investment comes out to be ~86%. So, essentially investors are doubling their money every 1.11 years or every 14 months!
Final Thoughts
Our other top contenders were RoomShare and Cubix, but in the end team felt more comfortable investing in Ridevert. There were several reasons for that most important one being Cubix’s scathing similarity to a bigger and better competitor Riverain and Roomshare’s broken website. In our final term sheet, we also proposed to nominate one member in the board and we suggested deduction of 15% options pool from founder’s stake. Additionally, we set liquidation preference to 1.2X and weighted average anti-dilution clause to counter against any undesirable outcome. We also decided to ask for 8% cumulative dividend, which, in hindsight, we realize was probably overkill for a paltry investment of $60K for a firm, which manages a $100M fund. Before competition, as proxy VCs, we were too conservative about our investment, making sure every aspect of term sheet prevents our investment in case of any unfavorable eventuality. However, after competition, we learnt the value of negotiation and importance of building personal relationship with entrepreneurs. One of the judges went on to say, “VC’s need to own the startups like a baby and help them grow in any way they can”. Moral of the story is once you decide to invest in a startup you need to act like you “own it” as much as founders do. In the end, it was a great learning experience for me. I enjoyed the luxury of owning a $100 M fund as well as misery of deciding which firm to invest in. It was no less than a thrilling Shark Tank episode, and of course who doesn’t wanna play Kevin O’Leary, even if it was just for a day!
For those of you, who are still curious about our evaluation process and how did we narrowed down to Ridevert. All the documents including our final Term Sheet, Ridevert Valuation Excel, and initial brainstorming document can be found here. If you have any suggestions/ideas on how one should go about valuing a start-up please feel free to share it in comments below.
Peace!
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